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General Equilibrium Analysis and Economic Efficiency

This chapter discusses general equilibrium analysis and its role in determining prices and quantities in all markets simultaneously. It explores the efficiency of exchange, equity and efficiency, efficiency in production, and the gains from free trade.

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General Equilibrium Analysis and Economic Efficiency

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  1. Chapter 16 General Equilibrium and Economic Efficiency

  2. Topics to be Discussed • General Equilibrium Analysis • Efficiency in Exchange • Equity and Efficiency • Efficiency in Production Chapter 16

  3. Topics to be Discussed • The Gains from Free Trade • On Overview--The Efficiency of Competitive Markets • Why Markets Fail Chapter 16

  4. General Equilibrium Analysis • Partial equilibrium analysis presumes that activity in one market is independent of other markets. Chapter 16

  5. General Equilibrium Analysis • General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account. Chapter 16

  6. General Equilibrium Analysis • A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets. Chapter 16

  7. General Equilibrium Analysis • Two Interdependent Markets--Moving to General Equilibrium • Scenario • The competitive markets of: • Videocassette rentals • Movie theater tickets Chapter 16

  8. Assume the government imposes a $1 tax on each movie ticket. General Equilibrium Analysis: Increase in movie ticket prices increases demand for videos. S*M SV SM $3.50 $6.35 $3.00 D’V $6.00 DM DV QV Q’V Q’M QM Two Interdependent Markets: Movie Tickets and Videocassette Rentals Price Price Number of Movie Tickets Number of Videos

  9. The increase in the price of videos increases the demand for movies. The Feedback effects continue. SV SM $6.82 $6.75 $3.58 D*V $3.00 D*M $6.00 D’M DM DV QV Q*V Q”M Q*M QM Two Interdependent Markets: Movie Tickets and Videocassette Rentals Price Price S*M $3.50 $6.35 D’V Number of Movie Tickets Number of Videos Q’V Q’M

  10. Two Interdependent Markets: Movie Tickets and Videocassette Rentals • Observation • Without considering the feedback effect with general equilibrium, the impact of the tax would have been underestimated • This is an important consideration for policy makers. Chapter 16

  11. Two Interdependent Markets: Movie Tickets and Videocassette Rentals • Questions • What would be the feedback effect of a tax increase on one of two complementary goods? • What are the policy implications of using a partial equilibrium analysis compared to a general equilibrium in this scenario? Chapter 16

  12. The Interdependence of International Markets • Brazil and the United States export soybeans and are, therefore, interdependent. • Brazil limited exports in the late 1960’s and early 1970’s. • Eventually the export controls were to be removed, and Brazilian exports were expected to increase. Chapter 16

  13. The Interdependence of International Markets • Partial Analysis • Brazilian domestic soybean price will fall and domestic demand for soybean products would increase. Chapter 16

  14. The Interdependence of International Markets • General Analysis • In the U.S. the price of soybeans and output would increase; U.S. exports would increase and Brazilian exports would fall (even after regulations ended). Chapter 16

  15. Efficiency in Exchange • Exchange increases efficiency until no one can be made better off without making someone else worse off (Pareto efficiency). • The Advantages of Trade • Trade between two parties is mutually beneficial. Chapter 16

  16. Efficiency in Exchange • Assumptions • Two consumers (countries) • Two goods • Both people know each others preferences • Exchanging goods involves zero transaction costs • James & Karen have a total of 10 units of food and 6 units of clothing. Chapter 16

  17. The Advantage of Trade James 7F, 1C -1F, +1C 6F, 2C Karen 3F, 5C +1F, -1C 4F, 4C Individual Initial Allocation Trade Final Allocation Karen’s MRS of food for clothing is 3. James’s MRS of food for clothing is 1/2. Karen and James are willing to trade: Karen trades 1C for 1F. When the MRS is not equal, there is gain from trade. The economically efficient allocation occurs when the MRS is equal. Chapter 16

  18. Efficiency in Exchange • The Edgeworth Box Diagram • Which trades can occur and which allocation will be efficient can be illustrated using a diagram called an Edgeworth Box. Chapter 16

  19. Karen’s Food 4F 3F The initial allocation before trade is A: James has 7F and 1C & Karen has 3F and 5C. The allocation after trade is B: James has 6F and 2C & Karen has 4F and 4C. James’s Clothing Karen’s Clothing B 2C 4C +1C 1C 5C -1F A 6F 7F James’s Food Exchange in an Edgeworth Box 10F 0K 6C 6C 0J 10F

  20. Efficiency in Exchange • Efficient Allocations • If James’s and Karen’s MRS are the same at B the allocation is efficient. • This depends on the shape of their indifference curves. Chapter 16

  21. Karen’s Food A: UJ1 = UK1, but the MRS is not equal. All combinations in the shaded area are preferred to A. D James’s Clothing Karen’s Clothing C UJ3 B UJ2 A Gains from trade UJ1 UK3 UK2 UK1 James’s Food Efficiency in Exchange 10F 0K 6C 6C 0J 10F Chapter 16

  22. Karen’s Food D James’s Clothing Karen’s Clothing C UJ3 B UJ2 UJ1 UK3 UK2 UK1 James’s Food Efficiency in Exchange 10F 0K 6C Is B efficient? Hint: is the MRS equal at B? Is C efficient? and D? A 6C 0J 10F Chapter 16

  23. Efficient Allocations Any move outside the shaded area will make one person worse off (closer to their origin). B is a mutually beneficial trade--higher indifference curve for each person. Trade may be beneficial but not efficient. MRS is equal when indifference curves are tangent and the allocation is efficient. Karen’s Food 10F 0K 6C D Karen’s Clothing James’s Clothing C UJ3 B A UJ2 6C 0J 10F UJ1 UK3 UK2 UK1 James’s Food Efficiency in Exchange Chapter 16

  24. Efficiency in Exchange • The Contract Curve • To find all possible efficient allocations of food and clothing between Karen and James, we would look for all points of tangency between each of their indifference curves. Chapter 16

  25. E, F, & G are Pareto efficient . If a change improves efficiency, everyone benefits. Contract Curve G F E The Contract Curve Karen’s Food 0K James’s Clothing Karen’s Clothing 0J James’s Food Chapter 16

  26. Efficiency in Exchange • Observations 1) All points of tangency between the indifference curves are efficient. 2) The contract curve shows all allocations that are Pareto efficient. • Pareto efficient allocation occurs when trade will make someone worse off. Chapter 16

  27. Efficiency in Exchange • Application: The policy implication of Pareto efficiency when removing import quotas: 1) Remove quotas • Consumers gain • Some workers lose 2) Subsidies to the workers that cost less than the gain to consumers Chapter 16

  28. Efficiency in Exchange • Consumer Equilibrium in a Competitive Market • Competitive markets have many actual or potential buyers and sellers, so if people do not like the terms of an exchange, they can look for another seller who offers better terms. Chapter 16

  29. Efficiency in Exchange • Consumer Equilibrium in a Competitive Market • There are many Jameses and Karens. • They are price takers • Price of food and clothing = 1 (relative prices will determine trade) Chapter 16

  30. Begin at A: Each James buys 2C and sells 2F Each James would move from Uj1 to Uj2, which is preferred (A to C). Price Line PP’ is the price line and shows possible combinations; slope is -1 P C Begin at A: Each Karen buys 2F and sells 2C. Each Karen would move from UK1 to UK2, which is preferred (A to C). UJ2 A UJ1 P’ UK2 UK1 Competitive Equilibrium Karen’s Food 10F 0K 6C James’s Clothing Karen’s Clothing 6C 0J 10F James’s Food

  31. UJ2 UJ1 UK2 UK1 Competitive Equilibrium Karen’s Food 10F 0K 6C Price Line At the prices chosen: Quantity food demanded (Karen) equals quantity food supplied (James)--competitive equilibrium. P James’s Clothing Karen’s Clothing C At the prices chosen: Quantity clothing demanded (James) equals quantity clothing supplied (Karen) --competitive equilibrium. A P’ 6C 0J 10F James’s Food

  32. Efficiency in Exchange • Scenario • PFand PC = 3 • James’s MRS of clothing for food is 1/2. • Karen’s MRS of clothing for food is 3. • James will not trade. • Karen will want to trade. • The market is in disequilibrium. • Surplus of clothing • Shortage of food Chapter 16

  33. Efficiency in Exchange • Questions • How would the market reach equilibrium? • How does the outcome from the exchange with many people differ from the exchange between two people? Chapter 16

  34. Efficiency in Exchange • The Economic Efficiency of Competitive Markets • It can be seen at point C (as shown on the next slide) that the allocation in a competitive equilibrium is economically efficient. Chapter 16

  35. Competitive Equilibrium Karen’s Food 10F 0K 6C Price Line P James’s Clothing Karen’s Clothing C UJ2 A UJ1 P’ UK2 UK1 6C 0J 10F James’s Food Chapter 16

  36. Efficiency in Exchange • Observations concerning C: 1) Since the two indifference curves are tangent, the competitive equilibrium allocation is efficient. 2) The MRSCF is equal to the ratio of the prices, or MRSJFC = PC/PF = MRSKFC. Chapter 16

  37. Efficiency in Exchange • Observations concerning C: 3) If the indifference curves were not tangent, trade would occur. 4) The competitive equilibrium is achieved without intervention. Chapter 16

  38. Efficiency in Exchange • Observations concerning C: 5) In a competitive marketplace, all mutually beneficial trades will be completed and the resulting equilibrium allocation of resources will be economically efficient (the first theorem of welfare economics) Chapter 16

  39. Efficiency in Exchange • Policy Issues • What is the role of government? Chapter 16

  40. Equity and Efficiency • Is an efficient allocation also an equitable allocation? • Economists and others disagree about how to define and quantify equity. Chapter 16

  41. Equity and Efficiency • The Utility Possibilities Frontier • Indicates • the level of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve. • all allocations that are efficient. Chapter 16

  42. *Any point inside the frontier (H) is inefficient. *Combinations beyond the frontier (L) are not obtainable. OJ L E F *Movement from one combination to another (E to F) reduces one persons utility. *All points on the frontier are efficient. H G OK Utility Possibilities Frontier Karen’s Utility Lets compare H to E and F. James’s Utility Chapter 16

  43. Karen’s Utility OJ E F H G OK James’s Utility Equity and Efficiency • E & F are efficient. • Compared to H, E & F make one person better off without making the other worse off. Chapter 16

  44. Karen’s Utility OJ E F H G OK James’s Utility Equity and Efficiency • Is H equitable? • Assume the only choices are H & G • Is G more equitable? It depends on perspective. • At G James total utility > Karen’s total utility Chapter 16

  45. Karen’s Utility OJ E F H G OK James’s Utility Equity and Efficiency • Is H equitable? • Assume the only choices are H & G • Is G more equitable? It depends on perspective. • H may be more equitable because the distribution is more equal, therefore, an inefficient allocation may be more equitable. Chapter 16

  46. Equity and Efficiency • Social Welfare Functions • Used to describe the particular weights that are applied to each individual’s utility in determining what is socially desirable Chapter 16

  47. Four Views of Equity • Egalitarian • All members of society receive equal amounts of goods • Rawlsian • Maximize the utility of the least-well-off person Chapter 16

  48. Four Views of Equity • Utilitarian • Maximize the total utility of all members of society • Market-oriented • The market outcome is the most equitable Chapter 16

  49. Equity and Efficiency • The Social Welfare Function and Equity • Equity is dependent on a normative priority ranging from Egalitarian to Market-orientation. Chapter 16

  50. Equity and Efficiency • Equity and Perfect Competition • A competitive equilibrium leads to a Pareto efficient outcome that may or may not be equitable. Chapter 16

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